BM1913

ECONOMIC DECISIONS

Make or Buy
The following are the two (2) major economic decisions of organizations (Myerson, 2015):
• Procurement. The process of managing a broad range of procedures associated with a firm’s need
to acquire goods and services required to manufacture a product (direct) or to operate the
organization (indirect).
• Strategic sourcing. The process which takes the procurement process further by focusing more
on supply chain impacts of procurement and purchasing decisions, and works cross-functionally
within the business firm to help achieve the organization’s overall business goals. This includes
analysis of the company’s annual spending with suppliers and supply markets and helping to
develop a sourcing strategy that both supports the overall business strategy while minimizing cost
and risk.
The make or buy decision represents the choice between internal production and external sources. A
simple breakeven analysis can be used to quickly determine the cost implications of a make or buy
decision in the following example.

ILLUSTRATION: If a firm can purchase equipment for in-house use for P500,000 and produce requested
parts for P20 each (assuming that the capacity of the new equipment will cover the demand) or they can
have a supplier produce and ship the part for P30 each, what is the correct decision: make (purchase new
equipment) or buy (outsource production)?

To arrive at the correct decision, a simple breakeven point must be calculated to determine the production
level where total revenue equals total expenses. A firm must buy or outsource production if the demand
is less than the breakeven point. Whereas, a firm must make or purchase new equipment to produce the
parts if the demand is greater than the breakeven point. The calculation for breakeven point involves the
cost to make each component versus the cost to purchase each component, as follows:
𝑃𝑃500,000 + 𝑃𝑃20𝑄𝑄 = 𝑃𝑃30𝑄𝑄
𝑃𝑃500,000 = 𝑃𝑃30𝑄𝑄 − 𝑃𝑃20𝑄𝑄
𝑃𝑃500,000 = 𝑃𝑃10𝑄𝑄
𝟓𝟓𝟓𝟓, 𝟎𝟎𝟎𝟎𝟎𝟎 = 𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸

KEY POINTS: As the breakeven point is 50,000 units, it is better for the firm to buy the part from a supplier
if demand is less than 50,000 units, and purchase the necessary equipment to make the part if demand is
greater than 50,000 units.

Outsourcing
Outsourcing involves hiring a third-party external service provider to perform a business function that is
traditionally performed in-house by the company's own employees. Some examples of business functions
that are commonly outsourced include logistics, especially distribution and transportation of goods and
services.

The following are the benefits of outsourcing (Myerson, 2015):

• Focus. Outsourcing non-core activities helps the business to concentrate on its core functions like
sales and marketing. Non-core activities are daily operations of a firm that add a little value to the
overall profitability of the business.
• Cost savings. Outsourcing is usually less expensive than keeping a business function in-house.

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• Reduced capital expenditures. Outsourcing frees an organization from investments in

technology, infrastructure, and people that make up the bulk of capital expenditure.
• Increased flexibility. Outsourcing can improve an organization’s reaction to fluctuations in
customer demand and technological changes.
The following are the risks to outsourcing (Myerson, 2015):
• Security risk. This involves losing sensitive data and confidentiality.
• Loss of control. This involves lesser to no control over operations and deliverables of activities
that an organization outsources.
• Quality problems. This involves unmatched capacities and inexperienced capabilities of
outsourcing providers to perform outsourced tasks.
• Loss of focus. This involves delays and inaccuracies in the work output due to insufficient time or
attention given by the outsourcing provider.
• Hidden costs. This occurs when the outsourcing terms and conditions are not clearly defined.
• Incompatible culture. This occurs when the philosophy of the outsourcing provider and the
location where a business outsources lead to poor communication and lower productivity.
Other Supply Chain Strategies
The following strategies are available to the supply chain manager (Myerson, 2015):
1. In-Sourcing. This is the opposite of outsourcing. Insourcing involves performing previously
outsourced functions, in-house. This can be a result of poor quality or low productivity
outsourcing.
2. Vertical Integration. This is used to develop the ability to take the function of a supplier or a
distributor. The integration can be forward, toward the customer. For instance, a mining company
of iron began establishing a steel factory. This means that the mined iron can now be used in
producing steel. The integration can also be backward, toward suppliers. For instance, a movie
distributor started creating its own content. This means that the movie distributor may now rely
on its own content, instead of partnering with third-party content providers. Vertical integration
is a strategy to improve cost, quality, and inventory, but requires capital, managerial skills, and
adequate demand.
3. Near Sourcing. This involves a strategic placement of business functions or activities close to the
location where products and services are sold to improve efficiency and reduce costs.
4. Few Suppliers. This strategy involves establishing a long-term relationship with a small number
of suppliers. The goal of this strategy is to enhance learning curve through collaboration. The
learning curve involves business progress as influenced by experiences and new skills.
5. Many Suppliers. This strategy is used for commodity products in many cases where price is the
driving decision factor and suppliers compete with one another.
6. Joint Ventures. These are formal collaborations between two (2) companies. The goal of this
strategy is to reduce risk, enhance skills, minimize costs, and increase profitability.
7. Virtual Companies. They use computer and telecommunications technologies to extend their
capabilities by working routinely with employees or contractors located in several geographic
regions. They also rely on a variety of supplier relationships to provide services when needed.
They usually have very efficient performance, low capital investment, flexibility, and speed.
The Procurement Process
The general steps involved in the procurement process are as follows (Myerson, 2015):
1. Identify and review requirements. This step involves classifying the procurement activities based
on two (2) categories (direct and indirect) depending on the consumption purposes of the
acquired goods and services.

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o Direct procurement. This is applicable to manufacturing activities only. It encompasses all

items that are part of finished products, such as raw material, components, and parts.
o Indirect procurement. This concerns operating resources that a company purchases to
enable its operations. This includes materials purchased in support of maintenance,
repair, and operations, including capital spent on plant and equipment.
2. Establish specifications. This step involves enforcing particular provisions or standards according
to quantity, price, and functionality.
o Quantity. In the case of small-volume requirements, purchasers need to find a standard
item. If a larger volume is needed, materials must be designed for economies of scale to
both reduce cost and satisfy functional needs. Economies of scale refers to the equivalent
saving in costs derived from increased level of production.
o Price. This relates to the use of the item and the worth of the product. For instance, the
average price of a particular commodity is P100. If the price of the given commodity goes
over this average price, then it would be better to look for another supplier that produces
the same quality of product at an average price or lower.
o Functionality. This relates to the users’ perceived value from using an item. This includes
performance and aesthetic expectations. For example, in evaluating the functionality of
a hand can opener, users often focus on how smoothly does it remove the top of cans as
well as how appealing is the design.
3. Identify and select suppliers. This step involves searching for potential suppliers or contractors
from a variety of sources, including the Internet, catalogs, salespeople, trade magazines, and
directories. Typically, this involves coming up with a long list of qualified suppliers prior selecting
the ultimate vendor. After identifying potential vendors, a request for information (RFI) shall be
issued to let the identified vendors know that the company is interested in some trade agreement.
RFI must include information about the interested party and the requested background from the
potential vendors. Then, a request for quotation (RFQ) or request for proposal (RFP) is issued to
selected suppliers to bid or quote on delivering specific products or services and will include the
specifications of the items/service. The suppliers are requested to return their bids by a set date
and time to be considered for selection. Discussions may be held on the bids, in many cases, to
clarify technical capabilities or to note errors in a proposal. This step also involves vendor
evaluation based on the following factors:
o Technical ability. This involves the capabilities of the potential vendor to help in
developing and improving products or services of the interested party.
o Manufacturing capability. This involves the consistency of the potential vendor in
meeting standard quality and specifications.
o Reliability. This involves the market reputation and financial stability of the potential
vendor.
o After-sales service. This involves unsolicited support of the potential vendor in terms of
technicalities.
o Location. This involves the proximity of the potential vendor to the interested party to
address efficiently the cases where support service is needed.
4. Determine the right price. This involves setting a basis for pricing and negotiation to arrive at the
optimum deal. Three (3) basic models are used as a basis for pricing:
o Cost-based. The value of the commodity is based on the expenses of the supplier to
create the item or raw material.
o Market-based. The value of the commodity is based on published, auction, or indexed
price. Index price is the average price of goods relevant to its given class or category. For

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example, the average price of a whole wheat bread is P70. This means that a whole wheat
bread can go a little above or a little below P70.
o Competitive bidding. The value of the commodity is based on a public proposal with the
intent that companies will put together their best proposal and compete for a specific
project.
5. Issue Purchase Orders. This step involves the delivery of proper documentation required to buy
materials between a buyer and seller. Purchase orders specifically defines the price,
specifications, and terms and conditions of the product or service and any additional obligations
for either party. The purchase order must be delivered by fax, mail, personally, email, or other
electronic means. Below are the types of purchase orders:
o Discrete. This is used for a single transaction with a supplier, with no assumption that
further transactions will occur.
o Pre-negotiated blanket. This is used for orders containing multiple delivery dates over a
period of time, usually with predetermined pricing, which often has lower costs as a result
of greater volumes on a longer-term contract. It is typically used when there is an ongoing
need for consumable goods.
o Pre-negotiated vendor-managed inventory (VMI). This requires suppliers to maintain an
inventory of items at the customer’s plant and the customer pays for the inventory when
it is actually consumed. This is usually used for standard, small-value items such as
maintenance, repair, and operating supplies (MRO) like fasteners and electrical parts.
o Bid and auction (e-procurement). This involves the use of online catalogs, exchanges, and
auctions to speed up purchasing, reduce costs, and integrate the supply chain.
o Corporate purchase card (pCard). This involves a company charge card that allows goods
and services to be procured without using a traditional purchasing process, sometimes
referred to as procurement cards or pCards. There is always some kind of control for each
pCard, such as a single-purchase peso limit, a monthly limit, and so on. A pCard holder’s
activity should be reviewed periodically independently.
6. Follow up to assure correct delivery. This step involves monitoring and managing scheduled
delivery dates to avoid possible missed dates in advance where possible. In some cases, delays
may be inevitable, and as a result, recovery plans must be developed and managed. To
collaboratively resolve problems, it is also critical to understand the supplier’s production process,
capacity, and constraints.
7. Receive and accept the goods. This step ensures that proper physical condition, quantity,
documentation, and quality parameters are met. Accomplishing this requires a cross-functional
activity among purchasing, receiving, quality control, and finance. Receiving is technically a non-
value-added activity from a customer perspective because it is designed to ensure that everything
up to that point has been done properly. The goal is to ensure quality throughout and to reduce
or eliminate the need for inspection. In many cases, technology such as barcode scanners and
handheld computers can automate the process. Some of the inspection processes can also be
reduced or eliminated by various inspection and certification processes being performed by the
vendor.
8. Approve invoices for payment. This step involves the approval of invoice for payment according
to the terms and conditions of the purchase order (PO). Any discrepancies in data must be
reconciled before payment is issued to the vendor.
Reference
Myerson, P. (2015). Supply chain and logistics management made easy: Methods and applications for planning,
operations, integration, control and improvement, and network design. United States: Pearson Education,
Inc.

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